Turbulent financial markets have not caused major shifts in institutional asset allocations, especially to hedge funds, according to a new report.

Three quarters of institutional investors said they do not plan to modify portfolio allocations. Further, while the study results indicate a moderate decline in overall allocations to hedge funds, the majority of institutions report an intention to increase or maintain current hedge fund allocations over the next 12 months.

“Hedge funds have not been immune to the extremely volatile market environment,” said Gary Enos, executive vice president and head of relationship management and client strategy for State Street’s Alternative Investment Solutions team. “While alternative investments, including hedge funds, largely outperformed traditional investments in 2008, negative returns understandably disappointed. Although hedge fund allocations declined slightly over the past year, we anticipate growth will resume later in 2009, as institutional investors continue to focus on diversification and risk management.”

The majority of funding for new hedge fund positions is expected to come from equity allocations (80%), as compared to 2007 when two in five institutions (39%) planned to draw from bond allocations to fund new hedge fund positions. Another encouraging sign for alternatives is increased institutional interest in private equity funds. Over half of institutions (53%) have allocated more than 5% of their portfolio to p.e. funds, and half intend to increase their allocation to p.e. over the next 12 months.

Among the challenges arising from the recent market volatility has been the growing difficulty in accurately valuing derivatives and other complex financial instruments. As a result, more institutions reported that accurately valuing hedge fund holdings can be problematic (77% versus 55% in 2007). Two-thirds of institutional investors (64%) attribute the accurate valuation of their hedge fund holdings to the use of an independent fund administrator, illustrating the valuable role that third-party providers can play.

Institutional investors also continue to emphasize transparency. Five out of six institutions (84%) expect more disclosure of hedge fund positions and nearly half (49%) anticipate more frequent reporting from hedge fund managers. Meanwhile, only a few (19%) currently receive some level of consistent transparency across hedge fund holdings.

By all accounts, institutional risk management programs are growing more sophisticated. While one-third of institutions place a greater emphasis on qualitative analysis when monitoring the ongoing performance of alternative investments, half place an emphasis on both qualitative and quantitative analysis. Further, nearly two-thirds (61%) of institutional investors either intend to (17%) or already are (44%) aggregating alternative investment risk exposures with other portfolio exposures to gain a meaningful assessment of risk across their portfolio.

“The recent unprecedented market volatility has prompted institutions to increase their focus on risk management,” said Enos. “To address these concerns and the increasingly difficult challenges inherent in the financial markets, the hedge fund community and allied third-party providers and administrators are stepping up efforts to develop and expand risk management solutions for institutional investors.”

Editor's Note

In our new section, FINtech Focus, we will profile one of these firms each week. While fintech is a broad category, we will be focusing on firms that specifically cater to the alternative investment industry. Read more…